Hitting the Banks

Just as regulation changes in the 1990s had their consequences in the 2000s, Obama is setting the stage for a crisis in the 2010s.

U.S. President Barak Obama put the cat among the market pigeons last week by announcing a rethink of what U.S. banks would be allowed to do.

The initiative was no idle thought balloon. Obama used all the prestige of his own position while invoking the name and reputation of Paul Volker to add credibility to the policy.

The so-called Volcker rule will not be as radical as the introduction of the Glass Steagall laws at the end of the great depression, in an earlier retaliation against bank misbehaviour. The Glass Steagall Act prevented banks from engaging in any securities issuing activities. Apparently, the Volcker rule would allow transactions on behalf of clients but block proprietary trading.

Glass Steagall was repealed in 1999 after U.S. banks and securities houses banded together to persuade U.S. legislators that they were losing competitiveness to their overseas counterparts. Abandonment of Glass Steagall precipitated a bout of mergers between banks and securities houses that created vast financial service supermarkets.

The breakdown of the distinction between banking and securities issuance was completed in 2008 after the global credit crisis. Financial trading firms like Goldman Sachs put themselves under the supervision of the Federal Reserve to get the protection afforded to traditional lenders and deposit takers.

Goldman Sachs was given this privileged status despite relying heavily for its profitability on proprietary trading. In many respects, Goldman Sachs was a hedge fund dressed up to look like a bank. As soon as there were signs that its freedom to trade might be compromised, it sought as speedy an exit as possible from the oversight which came with the emergency financing programs put up by the Congress in 2008 to get the financial system working again.

The determination of the banking majors to limit any constraints on their lines of business - widely perceived as ingratitude and a lack of remorse - clearly annoyed the U.S. administration.

The leading US bankers also appeared unrepentant when they appeared before the Financial Crisis Inquiry Commission set up by the congress to investigate the causes and consequences of the global credit crisis. They conceded in front of the Angelides commission that lessons had been learned and, with the benefit of hindsight, they would do some things differently. However, Goldman Sachs chairman Lloyd Blankfein, who faced the brunt of the questioning, stood firm in defence of his bank's trading activities.

The Obama administration, in common with governments elsewhere, must fund the budgetary repercussions of the credit crisis over the next two decades. As Australian Treasury Secretary Ken Henry has pointed out, taxes will have to rise. The only question is which taxes.

Whatever their initial incidence, the burden of nearly any new tax will fall ultimately on individuals either directly or through a reduction in their employment potential. Obama and the congressional Democrats know that they will be unable to raise taxes on anyone unless they first take the stick to the banks. This is simply the current political reality of life in the USA.

The first reaction to the Volcker initiative has been uncertainty. Not knowing how it will alter the profitability of the affected banks, markets fell. The drop was compounded by China's attempts to put a lid on bank lending, an embarrassing and tactically important loss of a senate seat in the previous Democratic stronghold of Massachusetts and the senate baulking at confirming Ben Bernanke as Fed chairman. It was a tough week.

Barney Frank, the Massachusetts congressman who heads the House Financial Services Committee, opined that it might take as long as three years for the Volcker rule to become law and come into effect. This was good and bad: there would be no immediate financial impact on the banks but the threat would linger well into the second term of the current president and possibly place the banks at the centre of the next two election cycles.

The biggest potential losers are the hedge funds dressed up as banks. If the new rules are implemented, they will be more constrained in how quickly their earnings can grow. Consequently, they will be less attractive investments. The stock owned by their employees will be worth less than they had thought. Their business models will be jeopardized.

The winners will be the traditional lending banks relying on deposit growth to build their asset bases. In the U.S., this will most likely be the regional and community banks rather than the large and diversified money centre banks. Similarly, foreign banks, finding themselves unconstrained by the Volcker rules, could benefit. The likes of HSBC and Santander, globally, and the four majors plus Macquarie, locally, would be potential beneficiaries.

Obama's congressional allies were quick to assert that most other countries will apply similar constraints so that U.S. banks will not be disadvantaged in competing for business. But "most" is unlikely to be good enough.

We have seen dramatic examples in recent years of minor countries like Iceland and Ireland putting in place favourable regulatory and tax regimes to attract offshore financial institutions. You only need one or two to affect the regulatory balance.

This and earlier history says that bankers will find the blandishments of any country breaking ranks irresistible. As their businesses gravitate toward the most enticing regulatory environments, they will set the stage for the next crisis.

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